A Review of the Accounting Cycle

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The Revenue/ Receivables/Cash Cycle
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Learning Objectives

• Explain the normal operating cycle of a business.
• Prepare journal entries to record sales revenue,
  including the accounting for bad debts and
  warranties for service or replacement.
• Analyze accounts receivable to measure how
  efficiently a firm is using this operating asset.

3
Learning Objectives

• Discuss the composition, management, and control
  of cash, including the use of a bank
  reconciliation.
• Recognize appropriate disclosures for presenting
  sales and receivables in the financial statements.

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Learning Objectives
EXPANDED MATERIAL

• Explain how receivables may be used as a source
  of cash through secured borrowing or sale.
• Describe proper accounting and valuation of notes
  receivable.
• Understand the impact of uncollectible accounts
  on the statement of cash flows.
• Use a petty cash fund.

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Revenue/Receivables/Cash Time Line
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The Operating Cycle of a Business
Cash
Accounts Receivable
Inventory
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Credit Sale and Collection
Assume that John purchased 1,000 of equipment on
account. What entries are made?
Assume that John purchased 1,000 of equipment on
account. What entries are made? When the
inventory is sold on account Accounts
Receivable................ 1,000
Sales..................................
1,000 Sold equipment to John on account.
Assume that John purchased 1,000 of equipment on
account. What entries are made? When the
inventory is sold on account Accounts
Receivable................ 1,000
Sales..................................
1,000 Sold equipment to John on
account. When the collection takes place
Cash..........................................
1,000 Accounts Receivable.........
1,000 Payment from John for equipment
purchased.
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Receivables
Receivables are all claims against other
entities. They are usually settled in cash.

• Trade receivables Receivables arising from
  normal operating activities.
• Nontrade receivables All receivables arising
  from activities other than normal operations.

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Sales Discounts--Gross Method
Assume 1,000 of equipment is sold on account.
The terms of the agreement are 2/10, n/30. What
are the collection entries?
If paid within the discount period Cash........
.................................... 980 Sales
Discounts...........................
20 Accounts Receivable.......... 1,000
If not paid within the discount
period Cash.....................................
... 1,000 Accounts Receivable.........
1,000
10
Sales Returns and Allowances
Felton Company sold 1,000 of merchandise. When
delivered, it was determined that the wrong color
had been sent. The customer agrees to keep the
merchandise for a reduction in price of 100.
What are the journal entries?
Sales entry Accounts Receivable (Cash)....
1,000 Sales................................
... 1,000
Sales allowance entry Sales Returns and
Allowances.. 100 Accounts
Receivable (Cash).. 100
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Sales Returns and Allowances
Felton Company sold 1,000 of merchandise. One
week later, when it was delivered, 100 in
merchandise (cost, 60) was the wrong color.
With Feltons approval, it was returned. What
are the journal entries?
Sales entry Accounts Receivable (Cash)....
1,000 Sales................................
... 1,000
Sales return entry Sales Returns and
Allowances.. 100 Accounts Receivable
(Cash).. 100 Inventory
60 Cost of Goods Sold.
60
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Sales Discounts and Sales Returns and Allowances
Income Statement Sales...........................
.................. 1,000 Less Sales
Discounts...................... 20
Sales Returns and Allowances 100 (120) Net
Sales..........................................
880
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Bad Debts

• Occur when customers do not pay for items or
  services purchased on credit.
• Bad debts are uncollectible accounts receivable.
• Bad Debt Expense is reported as a selling or
  general and administrative expense.
• Accounts receivable are reported on the balance
  sheet at their net realizable value.

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Accounting for Uncollectible Receivables (Direct
Method)
Write Off Bad Debts Expense. 400
Accounts Receivable. 400
To write off an uncollectible account.
This entry is made when the account has been
determined uncollectible. Since this
determination was made after the period in which
the sale takes place, the matching principle is
violated. This method is not accepted under GAAP.
15
Accounting for Uncollectible Receivables
(Allowance Method)
In this method, an estimate of the total
uncollectible accounts is made at the end of the
period, and an expense is recognized. Bad
Debts Expense.. 2,000
Allowance for Doubtful Accounts.. 2,000 To
record estimated uncollectible accounts.
GAAP requires use of the Allowance Method for
determining bad debts expense.
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Accounting for Uncollectible Receivables
(Allowance Method)
When the account is then determined to be
uncollectible, the write-off entry is
Allowance for Doubtful Accounts... 400
Accounts Receivable 400
To write off an uncollectible account.
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Accounting for Uncollectible Receivables
(Allowance Method)
(1) The Allowance for Doubtful Accounts is a
contra asset account which is subtracted from
Accounts Receivable on the balance sheet.
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Estimating the Allowance for Uncollectible
Accounts

• Percentage of credit sales.
• Percentage of accounts receivable.
• Aging receivables.

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Percentage of Credit Sales
Example Doubtful Accounts Expense
The ABC company had credit sales of 100,000.
The current accounts receivable balance is
30,500. The allowance for doubtful accounts
balance is 350 (Cr.). Historically, 3 percent
of the credit sales are not collected.
What is the entry to record estimated bad debts?
20
Percentage of Credit Sales
Example Doubtful Accounts Expense
The ABC company had credit sales of 100,000.
The current accounts receivable balance is
30,500. The allowance for doubtful accounts
balance is 350 (Cr.). Historically, 3 percent
of the credit sales are not collected.
Bad Debt Expense 3,000 Allowance for
Doubtful Accounts .. 3,000 To record estimated
uncollectible accounts for the year.
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Percentage of Credit Sales
Example Doubtful Accounts Expense
Allowance for Doubtful Accounts
Balance 350 Adjusting 3,000 Dec. 31, Bal. 3,350
22
Percentage of Accounts Receivable
Example Doubtful Accounts Expense
The ABC company had credit sales of 100,000.
The current accounts receivable balance is
30,500. The allowance for doubtful accounts
balance is 350. Historically, 5 percent of
accounts receivable are not collectible.
Bad Debt Expense.. 1,175
Allowance for Doubtful Accounts. 1,175
To record estimated uncollectible accounts for
the year.
What is the entry to record estimated bad debts?
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Percentage of Accounts Receivable
Allowance for Doubtful Accounts
Balance 350 Adjusting 1,175 Dec. 31, Bal. 1,525
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Percentage of Accounts Receivable
Allowance for Doubtful Accounts
What if the allowance account had a debit balance
of 300?
Adjusting 1,875 Dec. 31, Bal. 1,525
Balance 350
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Aging Receivables
The ABC company had credit sales of 100,000.
The current accounts receivable balance is
30,500. The allowance for doubtful accounts
balance is 350. The firm ages the accounts to
determine the expected uncollectibles.
Remember, because receivables are involved, the
amount derived from aging provides the desired
balance of the allowance account.
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Aging Receivables
Percentage
Estimated to be Age Balance Uncollectible
Amount Current.............. 21,000
1.5 315 1-30 days..........
5,000 4.0 200 31-90
days........ 2,800 20.0
560 Over 90 days..... 1,700 40.0
680 30,500 1,755
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Aging Receivables
Allowance for Doubtful Accounts
Balance 350 Adjusting 1,405 Dec. 31, Bal. 1,755
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Accounting for Warranties
Ednas Appliances sells washers and dryers with a
one-year warranty. Past experience indicates
that 15 of the appliances sold will need repairs
before the warranty expires. The average repair
cost is 80. In 2001, 500 washers and dryers
were sold. Actual repair costs for the year
totaled 3,400.
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Accounting for Warranties
To record estimated warranty expense
Warranty Expense.. 4,000 Estimated
Liability Under Warranties.. 4,000 To
record estimated warranty expense based on
units sold (500 x 80).
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Assessing Management of Receivables

• Average Collection Period The average number
  of days that elapse between the time that a sale
  is made and the time that cash is collected. It
  is calculated by dividing the average receivables
  by the average daily sales. The amount for
  average daily sales is determined by dividing net
  sales by 365.

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Assessing Management of Receivables
The Wheeler Company had net sales of 150,000
during 2002. Accounts receivable increased
35,000 to 40,000 during the same time.
Calculate the average collection period.
Average Collection Period Average Accounts
Receivable 37,500 Average Daily
Sales (150,000/365)
Average collection period 91.25 days
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Composition of Cash

• Undeposited coins and currency (change funds)
• Demand deposits
• Petty cash funds
• Cashiers checks
• Personal checks

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Composition of Cash
Many companies report investments in very
short-term, interest-earning securities as cash
equivalents in the balance sheet.
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Composition of Cash
A credit balance in the cash account is known as
a cash overdraft and should be reported as a
current liability.
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Control of Cash

• Specifically assigned responsibilities for
  handling cash receipts.
• Separation of handling and recording receipts.
• Daily deposit of all cash received.
• Voucher system to control cash payments
• Internal audits at irregular intervals.
• Double record of cash (bank and book) with
  reconciliation performed by someone outside the
  accounting function.

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Bank Reconciliation
A comparison of the bank balance with the books
balance by means of a summary is a bank
reconciliation.
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Bank Reconciliation
Common causes of differences

• Deposits in transit.
• Outstanding checks.
• Bank debits for items such as service charges and
  NSF checks.
• Bank credits for items such as the bank
  collecting a note for the depositor.
• Accounting errors.

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Loris Florist Bank Reconciliation March 31, 2002
Balance per books.............. 3,950
Additions to bank balance Direct
deposit................... 450
Interest.............................
71 Total............................
4,471 Deductions from book balance Service
charge........... 7 NSF
check................. 100 Error in recording
check 180 287 Adj. book balance
4,184
Balance per bank.... 4,135 Additions to
bank balance Deposits in transit....
500 Total................... 4,635
Deductions from bank balance Outstanding
checks 191....... 251 192.......
125 195....... 75 451 Adj. bank
balance 4,184
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Bank Reconciliation
All adjustments made to the Balance per Books
need to be recorded ADDITIONS
Cash. 521 Accounts
Receivable. 450 Interest
Revenue 71 DEDUCTIONS Accounts
Receivable (NSF) 100 Miscellaneous General
Expense (SC). 7 Recording Error, Underwritten
check... 180 Cash.. 287
Debited to original account.
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Accounts Receivable as aSource of Cash

• As a sale (either with or without recourse).
• As a secured borrowing.

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Accounts Receivable as aSource of Cash
SFAS 125 specified conditions that must be met if
a transfer of receivables is to be accounted for
as a sale

• The transferred assets have been isolated from
  the transferor and its creditors cannot access
  the assets.
• The transferee has the right to pledge or
  exchange the transferred assets.
• The transferor does not maintain effective
  control over the assets through an agreement to
  repurchase them before their maturity.

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Factoring Accounts Receivable
Factor
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Accounting for Factoring Accounts Receivable

• Close sold receivables.
• Close accompanying Allowance for Bad Debts.
• Expense any factoring charges.
• Establish a receivable for any sales price
  withheld by the factor.
• Debit Cash for net proceeds of the sale.
• Recognize a gain or loss from factoring.

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Example FactoringAccounts Receivable

• Assume
• Factored Receivables 10,000
• Allowance for Bad Debts 300
• Factor Withholding 5
• Sales Price 8,500

Journalize this transaction.
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Example FactoringAccounts Receivable

• Cash. 8,075
• Receivable from Factor... 425
• Allowance for Bad Debts 300
• Loss from Factoring Receivables... 1,200
• Accounts Receivable. 10,000
• Computations
• Cash 8,500 - 425 8,075
• Factor Receivable 8,500 x 5 425
• Factoring Loss (10,000 - 300) - 8,500
  1,200

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Sale of Receivableswith Recourse
Sale of receivables with recourse is different
from factoring, since factoring is normally sold
on a nonrecourse basis.
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Sale of Receivableswith Recourse
Continuing the previous example, assume that the
receivables were sold with recourse and it is
estimated that the recourse obligation has a fair
value of 500.
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Sale of Receivableswith Recourse
The entry to record the sale
Cash. 8,075 Receivable from
Factor... 425 Allowance for Bad
Debts 300 Loss on Sale of Receivables... 1,7
00 Accounts Receivable... 10,000 Recourse
Obligation 500
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Secured Borrowing

• Assignment of Accounts Receivable
• There are no special accounting problems
  involved.
• Simply record the loan.
• Specific Assignment
• Specified accounts receivable pledged.
• Accounts receivable reclassified on balance
  sheet.
• Notes disclosure of loan provisions required.

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Notes Receivable
A promissory note is an unconditional written
promise to pay a certain sum of money at a
specified time.
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Notes Receivable

• Initially recorded at present value.
• Two types
• Interest-bearing Interest rate is stated on the
  note.
• Non-interest-bearing Interest rate is not
  specified on the note, but the face amount
  includes the interest charge.

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Example Notes Receivable

• Assume
• Note Receivable 1,000
• Interest Rate 10
• Time to Maturity 2 years
• Journalize this note as
• 1. An interest-bearing note.
• 2. A noninterest-bearing note.

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Example Notes Receivable
Interest-Bearing Note Notes Receivable... 1
,000 Sales .. 1,000
Noninterest-Bearing Note Notes
Receivable.. 1,210 Sales..
1,000 Discount on Notes Receivable..
210 (PV of 1,000 _at_ 10 for 2 years 1,210)
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Discounting Notes Receivable

• Discount Rate The interest rate charged by the
  financial institution for buying a note
  receivable.
• Discount Period The time between the date a
  note is sold to a financial institution and its
  maturity date.

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Formulas for Discounting Notes

• Interest Face Amount x Interest Rate x
  Interest Period
• Maturity value Face Amount Interest
• Discount Maturity Value x Discount
  Period x Discount Rate
• Proceeds Maturity value - Discount

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Example Discounting
The original note is a 3-month, 1,000 note at
14 interest. What is the journal entry if the
note was discounted after one month at 16?
Interest 1,000 x .14 x 3/12
35.00 Maturity value 1,000 35
1,035.00 Discount 1,035 x .16 x 2/12
27.60 Proceeds 1,035 - 27.60
1,007.40
Cash. 1,007.40 Interest
Revenue... 7.40 Note
Receivable... 1,000.00
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The End